Overall, we expect most of the automotive aftermarket companies we rate will experience flat or declining revenue in 2023. In the aftermarket space, there are three types of companies that feature slightly different fundamentals: discretionary, non-discretionary, and semi-discretionary (see Table 1). We view products like custom wheels, truck bed covers, lift kits, and premium parts for hobby and enthusiasts as discretionary products. Alternatively, we view some parts, like tires, wipers, filters, and certain brake parts, as semi-discretionary because their maintenance can be delayed beyond normal recommended changes. Lastly, we view some products, such as batteries, starters, and alternators and some mission-critical brake parts, as non-discretionary because they must be replaced immediately when necessary. We also note that some companies, like Goodyear and Clarios, produce a significant amount of parts for the original equipment manufacturers (OEMs; roughly 25% of sales), though they still derive the majority of their revenue and profit from the aftermarket.

Table 1

Supply and demand in the aftermarket

We expect the demand for discretionary and semi-discretionary products will soften later in 2023, with the margins on these products remaining at historically low levels. While S&P Global economists now forecast slightly positive U.S. GDP in 2023, we still expect a shallow recession amid ongoing credit tightening and volatility in the banking sector, which could lead to increased downside risk. In 2022, the demand for discretionary products fell by about 20% following an unprecedented increase during 2021 when low interest rates and government stimulus led homebound consumers to increase their spending on their homes and cars. We now expect that consumer spending will be weaker this year and anticipate demand for discretionary products could fall 10%-15%. For semi-discretionary aftermarket parts, like tires, demand may only drop 3%-5%, though we think consumers may trade down to less-premium products, which would erode the suppliers' margins. While lower ocean and domestic freight rates will be a positive tailwind, we expect markdowns and decreased operating leverage from reduced demand will lead to weaker margins and free operating cash flow (FOCF) this year.

Rising inflation reduced the margins of non-discretionary auto parts suppliers in 2022 despite demand remaining relatively steady. We continue to expect the demand for non-discretionary aftermarket products will remain resilient over the next several years for a number of reasons. For example, the average age of vehicles continues to increase, particularly because supply chain disruptions and affordability concerns reduced the volume of new and used vehicle sales over the last couple years, with the average age accelerating to over 12.0 years from about 11.5 years prior to the pandemic. The volume of vehicle miles traveled has also recovered substantially from the lows reached during the pandemic, which will likely support increased demand for vehicle maintenance (see Chart 1).

Chart 1

Key risks and recent issues for aftermarket suppliers

The performance of the aftermarket suppliers depends on their ability to engineer and manufacture quality products, sell those products through various channels, and fulfill orders on a timely basis. Their success is determined by various market forces, including their brand strength, competition from other suppliers and private-label brands, fluctuations in raw material and freight costs, import tariffs, the strength of their distribution network, and their relationships with their customers (whether they sell through large retail chains or the increasingly popular direct-to-consumer channel).

In the last year, aftermarket suppliers have faced headwinds from elevated inflation in almost every aspect of their business. For example, these companies faced shipping container shortages and port and warehouse labor constraints, which contributed to a sharp rise in their freight, logistics, and labor costs amid excessive consumer demand fueled by fiscal stimulus. In addition, the prices for their key raw material inputs, including aluminum, rubber, steel, and plastic, increased substantially in a short period even as consumer demand for more discretionary products started to decline. These factors led to a significant contraction in the margins of the companies that were unable to increase their pricing amid the weakening consumer environment, specifically the more discretionary parts suppliers. Companies like Goodyear, First Brands, Clarios, and Burgess Point that make non-discretionary or semi-discretionary products have largely been able to pass on higher input costs to their customers. However, this may become more difficult later in 2023 when we anticipate the U.S. will enter a recession.

While certain aftermarket suppliers have taken advantage of the cheap production costs in China, we believe the benefits of offshoring have recently been offset by the fragility of their elongated supply chains and the risk for rising tariffs. The Trump Administration implemented significant tariffs on many aftermarket parts made in China, which led producers to increase their prices to offset these added costs. While most suppliers weathered this fairly well amid the strong demand environment, the risk for further tariffs remains.

The more significant underlying risk to manufacturing abroad emerged in 2022 when suppliers like Wheel Pros and Power Stop anticipated that their sales volumes would remain high. These suppliers decided to increase their inventories to ensure that they could fulfill the booming demand they had been experiencing during the pandemic. However, when demand fell sharply last year, it was hard for these suppliers to slow their orders due to the long lead times related to their elongated supply chains. This led to significant working capital investment, which was exacerbated by the declining demand for their products as their inventories ballooned. Many of these companies experienced significant cash outflows and faced downward ratings pressure. That said, suppliers have recently pulled back on their inventory orders to reduce their working capital usage, reduce their cash burn, and preserve liquidity.

Inflation and the weakening consumer environment have already led us to take a significant number of rating actions in this segment over the last 12 months (see Chart 2 and Table 2). This is because the weaker demand, margin declines, and increased interest expense at these companies led to lower-than-anticipated earnings, cash outflows, and--in some cases--reduced liquidity.

Chart 2

Table 2

Stress tests on aftermarket issuers

S&P Global Ratings' most recent macroeconomic forecast assumes a shallow recession during 2023, though we now expect U.S. GDP will expand modestly by 0.7%. Therefore, we performed a hypothetical scenario analysis of the aftermarket automotive suppliers we rate assuming a further decline in their EBITDA margins in 2023. We then compared the resulting credit metrics to our respective downgrade thresholds (all else remaining equal). For this test, we limited the offsetting actions that companies could take to mitigate negative factors (optimize costs, increase prices, reduce working capital investment and capital expenditure, hedge interest rates, and decrease share buybacks and acquisitions). We then looked at their debt to EBITDA, FOCF, and FOCF to debt relative to their current liquidity and cash interest coverage. At the 'B-' level or lower, the primary downside risk is that the companies will run out of liquidity as their negative free cash flow depletes their cash balances and revolver availability. Given already elevated interest rates, our stress test focused on EBITDA margin contraction. In particular, we looked at margin contractions of 150 basis points (bps) and 300 bps.

Table 3

Conclusions from our stress analysis

Our analysis of these companies shows they have a very limited cushion for underperformance. For companies we rate 'B+' or higher (Goodyear, First Brands, Clarios), we focused on both their debt to EBITDA and FOCF to debt triggers. For the majority of the companies we rate in the 'B-' category and lower, our downside ratings thresholds relate to their free cash flow generation, liquidity, and fixed charge coverage because we believe these metrics are more important than leverage in determining the long-term sustainability of their capital structures.

Our conclusions include:

• FOCF to debt: Cash flow, already thin or negative for most 'B-' rated aftermarket companies, clearly weakens further in 2023 assuming their margins contract. We also looked at the level of negative cash flow relative to current liquidity in each case to determine the magnitude of any cash flow deficits; and
• Interest coverage: The impact of contracting margins on EBITDA to cash interest in 2023 is modest, although their coverage levels are already weak due to high benchmark interest rates. There are a few issuers that currently have very weak interest coverage (Wheel Pros, Burgess Point, Power Stop, RealTruck, and K&N).

Based on the stressed scenarios, we determined which companies face greater risk of a negative rating action. We then assigned that risk as high, moderate, and low. We also considered that companies with more non-discretionary or semi-discretionary products would be less likely to experience our stressed case. Under our downside stress scenario, 30% of the companies faced significant risk of a negative ratings action, 50% faced moderate risk, and 20% faced low risk.

Table 4

Refinancing risk not a near-term concern

Issuers in our aftermarket universe benefit from flexible capital structures with long-dated maturities averaging almost five years across our ratings distribution. Longer-dated maturities are a function of the frequent transaction activity in the aftermarket segment of the automotive universe over the past couple of years that involved several leveraged buyouts and frequent merger and acquisition (M&A) activity.

Chart 3

High propensity to pursue aggressive financial policies, including M&A and dividend recapitalizations

Financial sponsors have been highly acquisitive investors in the automotive aftermarket. This activity has led to the higher usage of leverage and more aggressive financial policies, including debt-financed M&A and dividend recapitalizations. These suppliers' higher margins, relative to those of the OEM suppliers, has enabled financial sponsors to be more aggressive in the aftermarket and we expect this trend to continue.

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